... surprising stuff from John Hussman ... especially the political opinion ...
Ken
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Sunday December 29, 2002 : Weekly Market Comment
Copyright 2002, John P. Hussman, Ph.D., All rights reserved.
The Market Climate for stocks remains characterized by unfavorable valuations and unfavorable trend uniformity, holding us to a defensive position. While we remain fully invested in favored stocks, we have removed the impact of market fluctuations from the portfolio through hedging, leaving us with the portion of risk inherent in our favored stocks that is a) not correlated with overall market fluctuations and b) cannot or should not be diversified away. It is that portion of risk that we expect to be compensated for taking. We have hedged the market risk because such risk has historically not been compensated during periods with both unfavorable valuation and trend uniformity, and we have diversified away much of the random movements of our individual stock holdings by allocating our funds to over 100 individual stocks in a wide variety of industries.
Now, it's certainly possible to fully shut down all risk taking. We could do that by holding Treasury bills. Or we could do it by holding a portfolio exactly matching some particular market index and then selling short that market index as a hedge (a riskless position that also earns roughly the T-bill rate by virtue of how options and futures are priced). But we do not want a riskless position. In a market with thousands of individual stocks, each with its own particular valuation, market action, financial strength, products, industry, management, and other factors, there are always some risks that are worth taking, so long as the undesirable risks can be avoided, hedged, or diversified away. That's our basic approach, and is why our funds are called "strategic." In short, we select particular risks that we believe will be compensated.
Our view is that no form of investment risk is always worth taking without regard to valuations, fundamentals, economic conditions, or market action. The strategy of buying and holding index funds for the long run is essentially a strategy that says that market risk is always worth taking. Yet the iron law of investing is that a security is nothing but a claim on a future stream of cash flows. Valuation is a crucial determinant of long-term returns. The higher the price an investor pays for those cash flows today, the lower the long-term rate of return earned on the investment..
The corollary is also true. The lower the long-term rate of return demanded by investors, the higher the price moves today. So clearly, changes in investors' attitudes toward risk will strongly affect short-term returns. If investors become more willing to take market risk, it is equivalent to saying that they are demanding a smaller risk premium on stocks (that is, a lower long-term rate of return). Prices rise as a result. Now, the fact that current stock prices are higher also implies that future long-term returns will be lower, but that's part of the deal.
So clearly, the returns to market risk can be expected to vary, depending on investment merit (favorable/unfavorable valuations), and speculative merit (favorable/unfavorable investor preferences for risk taking). Rather than assuming that these are always favorable, we read them out of actual market conditions. Given a set of future expected cash flows and a current price, we can read out the long-term return that stocks are priced to deliver. If it's high, either in absolute terms or relative to suitably alternative assets, we say that stocks are favorably valued. If it's low, we say that stocks are unfavorably valued. We read out investor preferences for risk taking by analyzing market action - specifically, this thing that I call "trend uniformity." Investors leave the footprints of their information and preferences through the action of prices and trading volume across a wide variety of security types and market internals.
At present, stocks lack both investment merit and speculative merit. That said, I'll still be surprised if the market doesn't recruit at least some degree of speculative merit (favorable trend uniformity) in the months ahead.
Shorter term, the market broke a 10-week line of consolidation on Friday, which was particularly unfavorable action. Given that stocks are fairly oversold, favorable seasonality this week may give the market some support in recovering. It's not unusual for the market to enjoy a bounce following a significant technical breakdown, and we certainly shouldn't rule it out here. Still, Friday's break was unfavorable action, and the implications could become rather ominous if the market doesn't enjoy much of a rebound in the immediate future. As always, the market conveys the greatest information when market action departs from what it should do. Already, stocks have suffered one of the poorest December performances on record, during what ought to be a seasonally favorable period and what is widely believed to be a new bull market (I'll refrain from comment, for fear of gagging). Suffice it to say that stocks should be able to recruit a bounce here, should being the operative word.
In any event, we'll only increase our exposure to market risk if stocks can recruit evidence of favorable trend uniformity. We will not substitute anything for this evidence. Not hope in favorable seasonal patterns. Not hope that the market can't decline for a fourth year, so it must be safe to buy on December 31st. Not hope in the Fed. Nothing but evidence.
That evidence remains hard to find, especially evidence of robust preferences by investors to take stock market risk. A particularly good review of recent market action comes from Dr. Bryan Taylor of Global Financial Data:
"The end of previous bear markets as in 1974, 1982, 1987 and 1990 displayed double bottoms with important characteristics that marked the end of those bear markets. First, volume declined as the market ran out of sellers at the bottom. Second, volume increased significantly once the new bull market began. Third, the move out of the bottom was sharp, with the stock market index rising dramatically, breaking the downtrend in the market, and registering several successive months of a rising stock market. The market rallied for 12 months in a row in 1935, 6 months in a row in 1942, 11 months in a row in 1949, 9 of 10 months in 1970, 6 months in a row in 1975, 9 months in a row in 1982, and 7 months in a row in 1991. Fourth, after the bull market began the time the market spent rising was greater than the time spent declining or moving sideways. Fifth, the market became significantly undervalued at the market bottom, attracting new investors.
"Unfortunately, none of these signs of a market bottom has occurred here. Despite dramatic four-day rises off of the bottoms in both July and in October, the market stagnated afterwards. The current bear market has seen heavy volume during declines, and light volume after the market rallies, just the opposite of the pattern in a bull market. The market has yet to run out of sellers, and the buying power needed to pull the market further up hasn’t appeared yet. Finally, the market hasn’t broken its downtrend, and the market remains overvalued."
Among other measures, investment advisory bearishness remains quite low, with the Investors Intelligence bearish percentage still well below the important 30% level (26.5% this week). Barron's magazine presents further bullish views in its latest poll of Wall Street investment strategists. The bullish views lean heavily on two fallacies. One is the notion that the market can't decline four years in a row, since the only other time it has done so was during the Depression, and we're not in a depression. The difficulty is that the decline from the 2000 peak began at a price/peak earnings multiple fully 50% higher than the valuation that existed at the 1929 peak (or any other bull market peak for that matter). Valuation multiples based on other fundamentals such as dividends, book value, revenues, and replacement values were even more extreme in relation to prior bull market peaks. Even today, the S&P 500 price/book ratio remains above 4.0, which is beyond anything seen in prior market cycles.
The second fallacy is related, and is based on the notion that the P/E doesn't look so bad based on forecasts of future operating earnings. But basing stock valuations on such forecasts runs into the problem that a) they're forecasts, and have a history of outlandish unreliability, and b) stocks are not a claim on operating earnings, which include items such as interest payable to bondholders and taxes payable to the government. Moreover, given that the portion of operating earnings represented by debt and tax service is now the highest in history, it's not at all clear that the P/E multiple attached to those operating earnings should be anything close to the historical multiple attached to them.
Not that I'm arguing with bullish forecasts per se. I don't have a forecast at all, so it's certainly possible that the market could advance during 2003. If trend uniformity does improve in the months ahead, we'll certainly accept a moderate exposure to market risk. That said, I do disagree with the reasons that analysts are giving for being bullish. Valuations, in my view, simply do not belong among any well researched bullish argument, even taking into account the multitude of "but what about"s that people like to put forward to "correct" dismal valuations (most of these are discussed in prior updates and issues of Research & Insight).
So if the market recruits favorable trend uniformity in the months ahead, we'll take an exposure to market risk. That may occur at higher levels in the market, it may occur at lower levels, and it may not occur at all. But if trend uniformity does become favorable, it will not signify a return of long-term investment merit. Rather, we will have enough short-term speculative merit to warrant some additional risk taking (by reducing our hedging). In the meantime, we are already taking certain risks that we do expect to be compensated over time.
In bonds, the Market Climate remains characterized by unfavorable valuations and favorable trend uniformity. We've reduced our exposure to interest rate fluctuations somewhat by clipping off part of our Treasury bond positions during the recent rally, shifting into shorter-term callable agency securities, Treasury inflation protected securities, and other vehicles. Until trend uniformity shifts to an unfavorable condition, some interest rate risk will remain optimal. There is still enough risk in economic and political conditions to fuel a further decline in yields. But as I've noted before, the moment that economic activity picks up, inflation is likely to experience an abrupt spike higher. Deflation in manufactured goods (particularly foreign imports) is a possibility, but barring an outright debt crisis, fears of more widespread deflation are not well-supported.
I rarely discuss political risks, but these are becoming increasingly central to the investment markets. It is difficult to discuss war in relation to finance, because such discussions often appear terribly cold to the human tragedy of it. With the understanding that politics is never a subject that evokes agreement, here are my thoughts.
On a historical basis, war has not been particularly bad for the markets, because early uncertainty has been followed either by a certain numbness or by resolution. In both cases, risk premiums have initially spiked higher, followed by a decline. Prices move opposite to risk premiums, of course, leading to the characteristic sharp selloff and prolonged recovery related to war.
With regard to current risks, however, I don't think we can be so neutral about them. A military action in Iraq is likely to lead to much wider ramifications than the Gulf War. If the greatest fear of our enemies is that the U.S. is willing to use its power to threaten or prevent their sovereignty, what stronger way to validate these fears than to overthrow one of their governments? As a result, a military action in Iraq carries with it a much greater risk of retaliation in the form of renewed terrorist attempts. This would most probably drive risk premiums to high and fairly sustained levels, with economic effects on profits further depressing equity values.
The human risks to a war in Iraq are of far greater concern. Many of the "hawks" favoring war seem to have little combat experience, and are relying on a cakewalk to Baghdad - convinced that the U.S. made an error by failing to "finish the job" in the Gulf war. One wonders whether they recall that Eisenhower chose not to "finish the job" by making a northern push to Berlin in World War II. The Russians pushed ahead, and lost roughly 400,000 soldiers doing so - more than the U.S. lost in the entirety of World War II. The Iraqi army is certainly not the German army, but war, if it comes, will not be confined to the desert as it was during the Gulf War. The U.S. would certainly minimize casualties by destroying as much as possible from the air before land troops were deployed. But I doubt that the total number of casualties on both sides would be reduced by such destruction. Though we are Americans first, every life lost in war is a tragedy.
It strikes me that the U.S. has lost much of the international support and sympathy that it enjoyed last year, largely because of a White House foreign policy team that seems intent on escalation of conflicts to the exclusion of diplomatic alternatives. That's unfortunate, because already the White House's unfathomable doctrine of "preventive war" has provoked a destabilization of nuclear risks in North Korea. To a great extent, our enemies hate us not because of our freedoms, but because they believe that we are willing to deny them the same freedoms that we defend for ourselves. If our enemies understood America from the standpoint of its principles, its ideals, and its people, they would see these fears as unreasonable. But such fears can certainly be fanned by the foreign policy of a particular Administration, and this one is doing a good job of it.
The heightened nuclear tension in North Korea is a predictable response from a country identified as the third vertex of an "axis of evil," in the face of a planned military overthrow of one of the other vertices. What country, so identified, would not move to defend itself in the face of a potential invasion of Iraq? Understanding this, the best answer from the White House would be some gesture to assure that the U.S. does not intend a preemptive attack on North Korea as well. The resolution of any dispute requires one to ask "To what is each side entitled?" - and North Korea has asked for a nonaggression pact. Even if our response falls short of such formality, there are certainly some gestures that the U.S. can make along those lines to de-escalate the threat there.
All peace is based on a willingness - however distasteful - to understand one's enemy. Hate and evil typically have their origins in fear, ignorance, suffering, and perceptions of injustice. It is always possible to make gestures that address these without compromising one's own security or justice.
Is the group of hawks in the White House wise enough to understand its enemies? Maybe not. U.S. foreign policy is increasingly based on the notion that enemies should be eliminated. But if our enemies believe the same thing, the equilibrium cannot be peace without devastating losses first. Escalation is a long road, and the end of that road may not be peace after all. As Zen master Thich Nhat Hanh says, there is no way to peace - peace is the way. Understanding our enemies requires us to contemplate their fears, ignorance, suffering, and perceptions of injustice - however distasteful that is to imagine. Understanding does not prevent us from defending ourselves, or from seeking justice, but it informs a multitude of decisions and actions that can help, and as a result, that can stabilize our world.
As we enter a new year, there seem to be no fewer risks than in the year that is ending. But always, we can be full of hope.
I want to thank you for the opportunity to come into your computer monitor every week to analyze, discuss, teach, rant, and occasionally make no sense at all. (Those of you who have flat panels are also forcing me to buff up, so thanks for that too). As always, I appreciate your business, and I hope that I have served you well. But most of all, I am thankful for your trust.
Wishing you health and happiness in the New Year. - John
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